Financial statements contain substantial information about your company's operating results and financial position. The profit and loss statement (P&L) and the balance sheet are the two basic financial reports that give you this information. Taking the time to better understand these reports will give you more control and a clearer picture of your business and how it’s performing. If you were putting your P&Ls away without reading through them, you are not on your own. However, getting a grasp on your P&L is crucial to knowing how to operate your business efficiently.
Almost all entrepreneurs start businesses because they are excited about the main work of the business - which probably isn’t accounting. Therefore most entrepreneurs aren’t fully at ease interpreting the regular monthly financial statements they receive.
There are countless entrepreneurs who never view their profit and loss statements because they do not comprehend them and details are too complex. While we can’t show you how to be a professional accountant, we will provide you with some basic principles that will help you through this essential financial tool, emphasize the key numbers for you to check and recommend some things you can ask about.
Before we start talking about the numbers, define the profit and loss statement as a report that shows the income, expenses, and resulting profits or losses of a company over a specific period of time.
Thus the first thing you need to check is the time period covered by the profit and loss statement. It’s generally a 12 month period or current financial year, however you shouldn’t merely make that assumption – you might be incorrect and your perception of the business’ results will be way off the target. There will be comparative figures alongside to the latest period. Therefore for each number you’re going to check it with the prior year to find out if, and by the amount, the number has improved or reduced.
Every P&L uses a straightforward formula - sales minus cost equals profit. It truly is that easy. All the rest is a matter of splitting sales or cost into further detail and putting in subtotals. Sales are usually shown at the top of the P&L. Costs are displayed below sales and profit is at the bottom. You might notice several subtotals when you look down the column, however it is still sales minus costs equal profit.
Regrettably, we occasionally use various terms for sales, costs and profits. This tends to make accounting appear harder than it really is. For instance, sales are usually termed revenue or income. Costs can be termed expenses and profits are sometimes called net income. In reality, the P&L itself may also be referred to as an income statement. These AKAs are tedious, but don’t let it discourage you.
The Profit and Loss Statement generally has the following format
Sales Revenue (or Sales)
- Cost of Goods Sold (COGS) or Cost of Service (COS)
- Operating (SG&A) Expense
- Interest, Gains, and Losses
- Income Tax Expense
So on the top line, we have the sum of the sales or revenues. And this is going to be sales or revenues from whatever you define as your core business. It shows the value of product sales made by the company during the period covered by the profit and loss statement.
Your company’s revenue could be broken into several distinctive sources. For instance, the sales of a car dealership can come from new-car sales or from parts or from service. Such an enterprise might decide to separate sales into those 3 parts. Generally, these 3 components will be added as one in a line named total sales.
Likewise, expenses are generally separated into different parts. To illustrate, you might notice material costs, labor costs and overhead displayed individually. You will find an unlimited number of ways to display expenses, however when you get below the Sales line all the rest you see is an expense, separated out in one method or another.
The most helpful ways to subdivide expenses is into those expenses which are directly related to providing your product or service and those that are not. Think about an enterprise that produces and sells various kinds of gadgets. There will be the expense of the parts used to create the gadgets, the expense of the employees who put together the gadgets and the expenses of the manufacturing plant. These expenses are known as cost of goods sold (COGS) since they are linked directly to the manufacturing of gadgets.
In a service company, this is referred to as the cost of service (COS). For instance, a landscaping maintenance service might include the expense of the employees who perform the job, petrol costs and the expense of additional equipment like fertilizer and grass seed. So cost of goods sold (COGS) is the product at cost, or the direct cost of producing this revenue.
Sales minus COGS are called gross profit (or gross margin). This is the income the business earns after it subtracts the expense of providing its product and/or services. Gross profit would be interpreted as the markup over the product costs. It is also the funds required to cover the additional costs related to operating the company while still generating a profit.
Then we subtract operating (or SG&A) expense to get operating income. Operating expenses of the business are not connected with the manufacturing of gadgets. SG&A stands for selling, general and administrative costs. These are all the period costs, all the other costs of running the business.
Operating income would be a picture of the profitability of the core business. It helps answer the question of whether the company priced their product or services high enough to cover all the product and period costs of delivering those goods or services.
After operating income, we subtract any interest expense or interest income, and then we adjust for gains or losses. Gains or losses we haven't talked about yet, but they're like revenues or expenses, except they are not part of your core operations. For example, if gadget manufacturer sold their office and had a gain. We would put that gain here because they are not in the real estate business.
After you make those adjustments you get pre-tax income. Then you subtract income tax expense to give you bottom line net income, which is also called earnings or net profit.
! Pay attention that profit and loss statement provides the results of business operations using accrual accounting. By accrual accounting, it means we're going to recognize things in the profit and loss statement based on business activities, not based on cash flows. And therefore it's important to note that Profit and Loss Statement bottom line - Net Profit does not equal the change in the cash because it's a measure based upon business activities, not purely cash flow.